In the days after the congressional hearings, Eliot Spitzer's ultimatum hung over the credit markets. He'd given the bond insurers five days to come up with billions of dollars of capital. Many shared Spitzer's sense of urgency. Congress wanted the auction-rate crisis solved before half of all the hospitals, school districts, museums, and sewer authorities in the country were bankrupted by rising debt costs.

Then, just five days after the hearings, MBIA ( MBI) announced it was making big changes. The company re-enlisted Jay Brown as its chief executive officer (CEO) and chairman of the board. Brown, who had taken the reins at MBIA after the bankruptcy of the Allegheny Health, Education, and Research Foundation (AHERF) and managed the company's strategy for exiting the tax-lien business, returned to address another crisis.

Brown announced that MBIA might split itself into two insurance companies -- one that backed municipal bonds and one that backed structured finance securities. To preserve cash, it would cut its dividend; to build up capital, it would stop insuring any structured finance deals for six months. Brown assured shareholders that there was hope for the company's triple-A rating. Although other bond insurers had failed to raise capital, MBIA had obtained $2.6 billion. If the rating companies wanted more capital, then MBIA would raise it, Brown said.

Brown's compensation was tied to the company share price, as it was during his previous tenure. He owned 618,456 shares when he rejoined the company. Under his new incentive plan Brown was eligible to receive an additional 1,634,000 shares. Brown sold part of his extensive car collection, which included Ferraris, Porsches, and BMWs, to buy 359,000 more shares with his own funds. If Brown could get the stock price back up to $70, his stake in the company would be worth more than $180 million. An executive-compensation expert put the value of Dunton's estimated severance package at $11 million, according to an article in the New York Times.

Bill Ackman's Battle

Brown also wasted no time before confronting Bill Ackman. "Many of you have asked me in the past few days whether there is something personal between us," Brown wrote in a public letter to shareholders. In fact, Brown wrote, he and Ackman were similar: Both were ''passionate in our beliefs" and "persistent in overcoming all obstacles." But, Brown told investors, he led a regulated financial institution that provided "security, jobs, and peace of mind to tens of thousands of institutions and millions of individual investors." Ackman, on the other hand, had a single-minded objective. "He will stop at nothing to increase his already enormous personal profits as he systematically tries to destroy our franchise and our industry." Be advised, Brown concluded: "His intent to force a collapse has no chance to succeed."

Even as Brown described for investors his plan to save MBIA's triple-A rating, Ackman was shopping around another idea. The plan he had sketched out for Spitzer at the diner was now a 14-page PowerPoint presentation, which Ackman presented to Eric Dinallo, the New York state insurance superintendent, and Robert Steel, undersecretary for domestic finance at the Treasury department. He also discussed it with officials at the White House Council of Economic Advisors and the Federal Deposit Insurance Corp.

The day after Brown returned to the helm at MBIA, Ackman made his plan public. He proposed that the insurance company be split in two, with the municipal insurance company becoming a direct subsidiary of the structured finance insurer, which in turn would be a direct subsidiary of the holding company. Dividends would pass up the chain, starting with the municipal insurer. Those dividends would be paid only if each company's board of directors was sure the company could maintain its triple-A rating.

MBIA responded quickly, releasing a statement that called the plan "a continuation of Mr. Ackman's campaign to profit from his short positions and credit-default swaps in the bond-insurance industry." The structure was no more than "an attempt to find some way to make true his predictions that the holding companies are or will soon become insolvent," Brown said. "Mr. Ackman should let the officials charged with regulating the industry do their jobs, instead of continuing a relentless media-driven campaign fueled only by personal financial gain."

Dinallo's office did not express enthusiasm. "Our concern with the Ackman plan is that it would split the company, and the structured side could be substantially downgraded, which would be bad for the banks," said David Neustadt, a spokesman for the New York State Insurance Department. "Our preference is a plan that keeps an AAA rating."

For that the New York State Insurance Department was going to need some help from Wall Street.

Before the bond insurance crisis, New York State Insurance Superintendent Eric Dinallo had been a regular at the Marshall Club. The attorney enjoyed dropping in to the hundred-year-old chess club for impromptu matches and organized tournaments. After graduating from the New York University School of Law, Dinallo chose his apartment for its proximity to the club, which is located in a townhouse on a quiet, tree-lined street in the West Village. Now, in the wake of the Valentine's Day congressional hearings, he was preoccupied with a much bigger game.

The banks, which had billions to lose if the bond insurers were downgraded, were the only hope for getting more capital into the ailing companies. But their relationships with the bond insurers were complex. Many of the banks were relying on bond insurers' triple-A guarantees to support the value of billions of dollars of CDOs they held on their balance sheets. Yet a number of banks had purchased credit-default swaps on the bond insurers themselves, in effect hedging their hedges. "Some were more short than long" the bond insurers, Dinallo explains. In other words, they might come out ahead if the bond insurers failed.

Trying to come to an agreement between the banks and the bond insurers "was the most complicated 3-D chess game you can imagine," Dinallo says. While the game dragged on, confidence in financial markets was faltering.

The most immediate problem was Ambac ( ABK), the second biggest bond insurer.

On Friday, Feb. 22, with New York disappearing under a blanket of snow and the stock market sinking toward a close, details of the game began to emerge. Charlie Gasparino, the CNBC on-air editor, told viewers that, according to unnamed sources, an Ambac bailout was imminent. The plan involved splitting Ambac in two and having the banks provide enough capital to assure that both its structured-finance and public-finance subsidiaries maintained triple-A ratings. Banks might provide as much as $3 billion in capital, and the deal could be completed by early next week, said Gasparino. Ambac's stock soared. Indeed, the entire market rallied on the report.

Citigroup ( C) was rumored to be leading the bailout. That wasn't too surprising given that of Ambac's $22 billion of CDOs backed by subprime mortgages, nearly $7 billion of the worst-performing securities had been underwritten by Citigroup.

Ackman had been trying to speak with someone at Citigroup all week. On Sunday, Feb 24, he drafted an e-mail to Vikram Pandit, the CEO of Citigroup; Brian Leach, the chief risk officer; and Robert Rubin, the former secretary of the Treasury and now an adviser to the bank. "Last week I attempted to reach Vikram," the email began. "Vikram's secretary called and said that Brian would return my call. Having not heard from Brian, I attempted to reach Brian by phone and email. Neither my call nor my email was returned. I have therefore concluded," he wrote, "that Citi may be making the same mistake that Warburg did with MBIA, namely making an investment without adequate due diligence."

Since no one was picking up the phone at Citigroup, Ackman would summarize his views in the email. "While $3 billion may be sufficient to stop some of the rating agencies from downgrading Ambac Assurance today, continued downgrades and losses on the underlying exposures will likely require substantial additional capital," Ackman continued. The figure was inconsequential when compared with Ambac's more than half a trillion dollars of outstanding exposures, Ackman added.

He advised the three men to think carefully about the type of investment they were rumored to be considering in Ambac. A backstop -- or an agreement to buy up newly issued shares if there was insufficient market demand -- would likely induce other equity investors, including a large number of retail investors, to invest alongside Citigroup. "If the investment works out poorly, as we anticipate that it will, there are significant reputational consequences for Citi that should be considered," Ackman wrote.

It wasn't the first time that week that Rubin had heard from Ackman. Several days earlier, Rubin had given an informal talk for parents and faculty at a school on the Upper East Side. When Rubin offered to take questions from the audience, Ackman -- seated in the front row -- put his hand up immediately. Before Ackman had a chance to ask his question, Rubin responded, "Bill Ackman! Let me guess. It must be about the bond insurers."

"No, actually it's not," Ackman said. What he wanted to know was whether Rubin, "as a member of the board, a smart guy, and the former head of Goldman Sachs ( GS)," was able to understand the kind of risks Citigroup was taking.

No, Rubin told him, he was not. He didn't elaborate. Nor did he provide any insights on the Ambac bailout.

The great game of risk transfer had gone on for years on Wall Street,enabling ever more lending, reducing bank capital requirements, and generating big fees. The whole business had always been a bit too good to be true. Now, the gamesmanship in one company bailing out another so it could bail out the first was stunningly obvious.

On Monday, Feb. 25, the market got a reprieve. Standard & Poor's announced that both MBIA and Ambac had passed the credit-rating company's updated stress test. Their triple-A ratings were affirmed.

"This dose of optimism for a narrowly averted wave of monoline downgrades could go a long way to restoring capital market confidence in the near term," Lehman Brothers Holdings analysts led by Jack Malvey in New York said in a report issued to clients.

On Tuesday afternoon, Moody's lobbed the ball back into Wall Street's court. The credit-rating company issued a statement saying it was going to give Ambac more time to raise capital. "Ambac is actively pursuing capital-strengthening activities that, if successful, are expected to result in the company's meeting Moody's current estimate of the triple-A target level," Moody's analyst Jack Dorer wrote.

The rating company also affirmed MBIA's triple-A rating, though it assigned a negative outlook.

At 1:09 p.m., Jim Chanos attached the Moody's release to an email message he sent around, expressing his take on the announcement: "Delusional, but concerned."

"MBIA AAs continue to rally," Erika Kreyssig, one of Pershing Square's traders, messaged Ackman, referencing the narrowing of the premiums on MBIA credit-default swaps (CDSs). Shortly after the Moody's announcement, the rates were quoted at about 600 basis points, a drop of 115 basis points. By 7:15 p.m., when Kreyssig sent the next update, the spreads had fallen another 50 basis points to 550 basis points. It now cost $550,000 a year to protect $10 million of MBIA debt.

Peter Plaut, an analyst at hedge fund Sanno Point Capital Management in New York, put it this way: "We've avoided the brink."

As concern over the bond insurers and their triple-A ratings built to a frenzy, Ackman, for the first time in a long time, was not part of the show. He'd gone back to Tierra del Fuego for more fly fishing, accompanied by his father, Larry Ackman; Paul Hilal; and several others, including Oliver White, the former fly-fishing instructor who had become a member of Pershing Square's investment team. They were back at the Kau Tapen Lodge, along the Rio Grande, where giant sea trout were running from the frigid Atlantic upstream to the Andes Mountains. While New York shivered through the worst of the winter, it was summer at Kau Tapen. Ackman's only contact with the markets and his office was through a satellite phone, and it was not reliable.

"Many men fish all their lives without realizing it's not the fish they are after," Thoreau wrote. There was a connection with nature, a camaraderie, a spirit of competition. At Kau Tapen, the anglers included "an attorney, a structured-finance banker, and a hedge fund manager -- a type-A competitive group," Hilal says.

The trout averaged around 12 pounds, but some were nearly 30. On the first day, Ackman caught the biggest fish and held the title for the next several days. Then Al Rankin, deputy chairman of the Federal Reserve Bank of Cleveland, caught "a monster," says Hilal. For a while Ackman's only concern was whether he could regain the title for catching the biggest fish.

Back in New York, Jay Brown wrote to shareholders again. He had Ackman on his mind. "If someone had purchased protection, say, in January of last year, when spreads on our five-year CDS were relatively benign, they would have paid about 40 basis points per year," Brown explained. That meant someone could have bought protection on $7.5 billion of MBIA debt for about $30 million in annual fees. Huge swings in the price of that protection over the last year meant that this hypothetical person would have gained and lost massive fortunes.

"On paper, the value of the trade peaked north of $2.6 billion" and had lost about half its value since, Brown wrote. "The reality is that for the guys who play in this $45-trillion zero-sum game, $30 million is chump change. It's also why, given the amount of money that can be made here, people will go to no ends insisting the company will be broke in mere weeks."

For now, all eyes were on Ambac and whether Wall Street could organize a bailout. To Bill Gross, who runs one of the world's biggest bond funds at Pacific Investment Management Company, the premise was absurd. "Rescuing the monolines is not a long-term solution," Gross wrote in the Financial Times. Bond insurance was a flawed idea that had helped to get the U.S. economy into the current mess. "Overly generous triple-A ratings" on securities and on bond insurers created "a bubble of immeasurable but clearly significant proportions," Gross explained.

"How could Ambac, through the magic of its triple-A rating, with equity capital of less than $5 billion, insure the debt of the state of California, the world's sixth-largest economy?" Gross wrote. "That the monolines could shoulder this modern-day burden like a classical Greek Atlas was dubious from the start," he added. The whole concept was foolish. "It is as if Barney Fife, television's deputy Sheriff of Mayberry in the Andy Griffith Show, promised to bring law and order to the entire country," Gross wrote.

Even Jay Brown marveled at the perceived role the bond insurers had come to play in the markets. In his letter to shareholders, he said, "The sheer folly of suggesting that MBIA, the largest financial guarantor, could be the linchpin holding up the market value of the global financial system has lit a bonfire under the financial press that has led to the daily speculation - or real-time, if you follow the TV networks -- about our fate."

Folly or not, that's what everyone was counting on when, on Feb. 29, the Ambac plan hit a snag. Before the market opened that day, Gasparino reported that the credit-rating companies had nixed Citigroup's plan to save Ambac. The rating companies wanted more capital and had sent the bank consortium back to the drawing board. Ambac shares fell, and another abysmal day followed for the stock market, with the Dow sliding more than 300 points.

Dinallo and Spitzer continued to work the phones to drum up support for Ambac. They divided the list, with Spitzer calling Citigroup, UBS ( UBS), Bank of America ( BAC), and Credit Suisse ( CS). The banks could either come up with the capital now to save Ambac's triple-A rating or come up with more capital later to offset the decline in the value of the securities they had hedged with the insurer. Ambac needed $1.5 billion, a fraction of the writedowns banks would face if the bond insurer's rating spiraled downward.

On Tuesday, March 4, Gasparino reported that a bailout of Ambac was progressing. The news made the stock the second-biggest winner in the Standard & Poor's (S&P) 500 Index that day. On Wednesday, Gasparino reported that Ambac might agree to a bank rescue that day. Talks with Citigroup and Barclays had continued past 10 p.m. the previous evening, a tidbit that the market found encouraging. Trading on the stock was halted by the exchange, pending an announcement expected around noon.

In a press release, Ambac said it would sell $1.5 billion of common stock and equity units to bolster its capital. The offering would be led by Credit Suisse. Others in the syndicate group included Citigroup, Bank of America Corporation, and UBS AG.

Traders on the fixed-income desk at Credit Suisse, who had helped to create the Open Source Model, which was predicting that Ambac would need much more than $1.5 billion to survive, were stunned. "We're underwriting this?"

They were not the only ones who were skeptical. "Based on our estimate that Ambac will eventually absorb about $11 billion of losses from insured CDOs and exposures related to mortgage-backed securities, $1.5 billion of new capital at first blush does not seem like enough to fix the capital-adequacy problem," Andrew Wessel, an analyst at JPMorgan Securities in New York, said in a research report on Thursday, March 6.

When Gasparino went on the air later that day, he said there was a backstop in the Ambac deal and private-equity investors might get involved. And it was just possible that the deal might be increased to $2 billion. He sounded out of breath. "If it blows up, if investors walk away, banks have agreed to buy it." So it was a bailout?

Late Thursday evening, March 6, the Ambac deal was completed. The company, which started the day with a market capitalization of less than $1 billion, raised $1.5 billion. Both Moody's and S&P affirmed Ambac's triple-A rating.

"The situation in the market probably couldn't have been worse. It's worse than I've seen in 40 years," Michael Callen, Ambac's chief executive officer, told Bloomberg Television News the next morning from his office. "Everybody is very, very pleased that the triple-A is now solid."

But was it enough? The Open Source Model said it wasn't.

JPMorgan ( JPM) was also calling for Ambac to take losses of around $11 billion.

Callen, looking exhausted after what had been a sleepless night, wanted to talk about Ackman, not JPMorgan. "There is a gentleman out there who has been given a big microphone a number of times," Callen said. "I won't mention his name; he's known around here as the ax man." Ambac, Callen said, had "drilled down" and found the underlying assumptions in Ackman's model to be "outlandish."

Conditions were not going to "deteriorate to the point where our civilization changes forever. I personally don't believe that. There are people paid to believe that," Callen said.

If you believed Ackman was right, Callen added, "you should short Microsoft. You should short everybody. Short Hank Paulson down in Washington."

Later that day, Governor Spitzer appeared on CNBC to assure viewers that Ambac would be able to maintain its triple-A credit rating for the foreseeable future: "A lot of parties helped make this happen, and it was important for the capital markets."

Although Moody's and S&P were willing to say -- at least for the time being -- that the two biggest bond insurers had triple-A ratings, not everyone was on board. Fitch Ratings, the smallest of the three rating companies, had downgraded Ambac several weeks earlier and was actively reviewing MBIA.

On the afternoon of March 7, MBIA issued a press release saying it had asked Fitch to stop rating its insurance company. Brown said he disagreed with the company's methodology, which required more capital to be held against guarantees on structured finance versus municipal bonds.

Fitch's model also had proven erratic, he said: "We have very little idea why Fitch's capital model produces the charges it does, and why it can change so rapidly at any point in time when there is no obvious change in our circumstances or in the credit market at large," Brown had written in a recent letter to shareholders.

After affirming MBIA's top rating with a stable outlook in January, Fitch had put MBIA back under review for a possible downgrade, Brown noted.

"Did the world really change that much in two weeks?" Brown asked. "The only event of note that I can think of is the fact that the other two agencies put us on review for possible downgrade in the intervening time period."

Fitch's chief executive officer, Stephen Joynt, wasn't so certain about Brown's motivations. "Is it because you are aware we are continuing our analytical review and may conclude that MBIA's insurer financial strength is no longer AAA?" Joynt said in an angry letter that Fitch made public.

"It would appear that rather than work with Fitch, your intention could be to emasculate our opinion by withholding information and subsequently discrediting our opinion as being uninformed," Joynt concluded.

MBIA had become very aggressive about discrediting people who were skeptical about it. Shortly after Brown returned to MBIA, the company hired a public relations consultant named Jim McCarthy. After a few weeks on the job, McCarthy emailed my editor, telling her that he had compiled a list of people who felt I had harassed them in the course of my reporting or misrepresented their views in articles. I had never received any complaints. ''This is egregious conduct," McCarthy wrote, adding that he would reveal the names of those who had complained, but only if my editor agreed not to share the names with me.

It seemed that the bond insurers tried to wring the skepticism out of the market in any way possible. Over at Ambac, all eyes had been on the share price following the equity sale. But the gains were meager, with the shares up just 4 cents from where the new issue was priced. Then the closing trades came scrolling across broker screens -- $7.38, $7.38, $7.39, $7.37 -- and then the price and the volume surged. At 4:05 p.m., several last-minute trades were reported at $9.50 on huge volume. These last-minute trades pushed the stock's gain for the day to $2.08, giving those who bought the newly issued Ambac shares a one-day return of 28%.

"People think something's going on because the print went up so high," Joseph Saluzzi, co-head of equity trading at Themis Trading LLC in Chatham, New Jersey, told Bloomberg News. "It doesn't look like it's a keypunch error since it was such a large block."

The stock was up. That's what mattered. On March 7, 2008, Ambac executives, insurance regulators, and investment bankers breathed a collective sigh of relief over the salvation of Ambac's triple-A rating.

But events were already conspiring to unwind that bit of confidence. That afternoon, a New York Times reporter contacted Spitzer about an outfit called the Emperor's Club.

That weekend, Spitzer huddled with aides and warned them about what to expect. The following Monday, at around 2 p.m., the story hit The New York Times's Web site: Spitzer had been linked to a New York-based prostitution ring.

The story was picked up immediately by CNN and CNBC, which broadcast the sketchy details into trading rooms around the world. The man who had hectored and prosecuted Wall Street for its moral failings had been caught in the tawdriest of scandals. It was shocking, though not exactly market-moving, information.

Then traders began to put the pieces together. The New York governor had played an unprecedented role in corralling the banks into backing an equity issue for Ambac. It seemed almost certain that without Spitzer's prompting, Ambac would have lost its triple-A rating. What if the bond insurers required more help in the future? There was at least one way to trade the news of Spitzer's downfall, and that was to sell the bond insurers. By the end of the day, Ambac shares erased all of Friday's late trading gains and ended the day down 23 percent. MBIA shares lost 10%.